In 1952, TIAA-CREF created the first variable annuity for college professors worried that their fixed pensions wouldn't keep pace with inflation. The concept was revolutionary: instead of a guaranteed fixed payment, retirement income would rise and fall with the stock market.
Variable annuities now come with surrender charges, mortality and expense fees, subaccount options, guaranteed minimum death benefits, and more riders than a motorcycle gang. Understanding these products is essential because they sit at the intersection of insurance and securities regulation—and because unsuitable annuity sales remain one of FINRA's top enforcement priorities.
Annuity Basics
An annuity is an investment contract between an individual and an insurance company. The owner invests money with the insurance company, either as a lump sum or in periodic payments. When the owner reaches retirement age, the insurance company will begin distributing payments.
Fixed Annuity: Guaranteed Rate of Return
In a fixed annuity contract, the insurer guarantees a specific rate of return. The insurance company invests premiums into the company's general account. Because the insurance company assumes the investment risk, a fixed annuity is not considered a security—it's an insurance product only.
Indexed annuities track an index and pay returns based on that index's performance. They are also considered fixed annuities and not subject to securities laws.
Fixed annuities expose annuitants to purchasing power risk (or inflation risk)—the risk that fixed payments will be worth less in real terms over time.
Variable Annuity: No Guaranteed Rate of Return
In a variable annuity contract, there is no guarantee of a specific rate of return. Customers choose from a menu of mutual fund-like investments. If investments perform well, the annuity value increases; if poorly, it decreases.
Since the investor selects the investment vehicles, variable annuities are considered securities regulated under securities laws. They must be sold with a prospectus.
Sellers of variable annuities must be:
- State registered to sell insurance products
- Registered to sell securities (Series 6 or Series 7)
Variable Annuity Phases
Funds from variable annuities are held in separate accounts, apart from the insurance company's general account. Within separate accounts, investors choose from subaccounts that operate like mutual funds. The investor bears the investment risk.
Accumulation Phase
During this phase, the customer contributes money and purchases accumulation units. These units grow (or shrink) based on investment performance.
Distribution Phase
When the customer begins receiving payments, they may take a lump sum, make random withdrawals, or annuitize the contract.
Upon annuitization, the customer becomes an annuitant. Accumulation units convert to a fixed number of annuity units based on life expectancy. Monthly payments depend on investment performance, age/sex, and payout option selected.
Contributions are typically made with after-tax dollars. Earnings grow tax-deferred. There is a 10% penalty on earnings withdrawn before age 59½. Earnings are taxed as ordinary income when withdrawn.
| Feature | Fixed Annuity (General) | Variable Annuity (Separate) |
|---|---|---|
| Investment risk | Insurance company | Owner |
| Investment decisions | Insurance company | Owner (from subaccounts) |
| Payout | Fixed, guaranteed | Variable, performance-based |
| Insurer insolvency | Assets at risk | Separate from insurer |
Characteristics & Payout Options
Death Benefit
If the annuitant dies during the accumulation period, the beneficiary receives a death benefit equal to total investments plus earnings (or total invested if the annuity lost money). The beneficiary pays income taxes on earnings.
Purchasing Annuities
| Type | How Purchased | Payout |
|---|---|---|
| Single premium deferred | Lump sum | Delayed |
| Periodic payment deferred | Scheduled payments | Delayed |
| Immediate | Lump sum | Begins in 30 days |
Test-Taking Tip: There is no periodic payment immediate annuity. If you're making periodic payments, you can't also be receiving immediate payouts.
Surrender Periods and Free-Look
The surrender period is the time the investor must wait before withdrawing without penalty (up to 10 years). Withdrawing early triggers a surrender fee.
The free-look period allows customers to cancel the policy within a certain time (typically 10+ days) at no charge.
Test-Taking Tip: Customers who need income in the near future, such as the elderly, should not consider deferred annuities. This is a key suitability consideration.
Payout Options (Settlement Options)
| Option | How It Works | Check Size |
|---|---|---|
| Life Income | Payments for life; stops at death | Largest |
| Life with Period Certain | Payments for life; if death occurs during period, beneficiary gets remainder | Medium |
| Joint Life with Last Survivor | Payments until both parties die; common for married couples | Smallest |
An annuitant chooses life with a 20-year period certain. They receive payments for life. If they die 8 years in, the beneficiary receives payments for the remaining 12 years.
Rules and Regulations
Federal Regulations
Variable annuities are regulated under the Securities Act of 1933 (must be registered with SEC, sold with prospectus), the Investment Company Act of 1940, and the Securities Exchange Act of 1934 (sold only by registered broker-dealers who are FINRA members).
Recommending Deferred Variable Annuities
- Potential surrender period and surrender charge
- Tax penalty for withdrawals before age 59½
- Various costs and fees (higher than mutual funds)
- Market risk exposure
A registered principal must approve applications within 7 business days.
Suitability Considerations
- Long surrender periods are unsuitable for elderly customers
- Appropriate for customers wanting death benefit assurance
- Customers needing near-term money should only consider immediate annuities
- Suitable for high tax bracket individuals (tax-deferred growth)
- Customers should max out IRA/401(k) before buying annuities (contributions not deductible)
- No extra tax benefit from holding annuity inside an IRA or 401(k)
Taxation
In a nonqualified annuity, contributions are after-tax. Earnings are taxed as ordinary income. Annuitized payments are split between taxable earnings and tax-free return of principal.
In a qualified annuity (like a 403(b)), contributions are pre-tax. All withdrawals are fully taxable.
Test-Taking Tip: Withdrawals from any retirement plan or variable insurance product are never subject to capital gains taxes—only ordinary income.
Variable Life Insurance
Variable life insurance is an insurance product that is also a security. Premiums are deposited into a separate account, and the death benefit varies with investment performance.
Variable life is permanent insurance—as long as premiums are paid, the policy stays in force. The premium amount is fixed, but the death benefit and cash value (amount that can be borrowed or withdrawn) vary.
- Mortality and expense risk charges: Cost of death benefit
- Sales fees: Agent commission
- Administrative fees: Insurer's expenses
- State premium fees: State-imposed taxes
- Investment management fees: Subaccount management
- Rider fees: Optional benefits (e.g., guaranteed minimum death benefit)
Summary & Key Points
Variable annuities sit at the crossroads of insurance and securities—offering tax-deferred growth with investment flexibility, but also carrying fees, surrender charges, and complexity that make suitability a paramount concern.
Annuity Basics
- Fixed annuity: Guaranteed return; general account; insurance product only
- Variable annuity: No guarantee; separate account; security requiring prospectus
- Accumulation phase: Customer purchases accumulation units
- Distribution phase: Units convert to annuity units; payments begin
Payout Options (Largest to Smallest Check)
- Life income: Largest; stops at death
- Life with period certain: Medium; beneficiary gets remainder of period
- Joint life with last survivor: Smallest; continues until both die
Key Terms
- Separate account: Where variable annuity assets are held
- Subaccounts: Investment options, similar to mutual funds
- Surrender period: Time during which early withdrawal triggers fee
- Free-look period: Time to cancel without charge (10+ days)
- Death benefit: Payment to beneficiary during accumulation phase
- Annuitize: Convert to annuity units and begin payments